What is a Construction Reserve

Do you know how the funds in a renovation loan or new construction loan are distributed a Borrower? The funds are typically disbursed through a construction reserve which is a tool used by lenders to ensure the project is completed successfully.

When financing new construction or a fix and flip project, a construction reserve is built into the loan structure by a Lender to fund the future costs of a construction or renovation project. These funds are often held by the Lender, or an intermediary called a Fund Control service provider. The funds are disbursed to the Borrower over the course of the project, typically after each phase of work has been completed.

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Why Do Lenders Create a Construction Reserve

The primary purpose of the construction reserve is to ensure that the loan proceeds are being applied to the project correctly. Lenders want to monitor how funds are being utilized because the value of the property securing the loan is heavily dependent upon the completion of the project per the specified development plan.

Let’s take a look at an example. Suppose a Lender funds a construction loan to build a single-family home. If the Borrower was unable to complete the construction because of cost overruns, or they used the loan proceeds for another project, or they simply fail to finish the house, the Lender would be in jeopardy of getting repaid. The construction reserve allows the Lender to track the progress and reduce the risk that there are insufficient funds to complete the project. Furthermore, if the Borrower is unable to complete the project, and assuming the Lender has disbursed the funds correctly, the Lender could choose step in with the remaining funds to finish the project.

How is a Renovation Reserve Created

Lenders create a construction reserve based upon the scope of work and construction budget. Let’s assume that a Borrower submits a $250,000 construction budget for a project. The Lender may create a Construction Reserve that matches the budget. The Construction Reserve will break down the budget into individual cost line items such foundation, electrical, framing, etc.. That line item budget will then be applied to a project schedule that estimates how much and when the reserve proceeds would be disbursed based upon the timeline of the project.  

Typically, Lenders will only disburse funds to the Borrower once the work as been completed. For example, if the construction reserve includes funds for a foundation, the Lender will only disburse funds to the Borrower once the foundation has been laid. Furthermore, they will only disburse the funds allocated in the budget to the foundation.

How to Submit a Draw Request

Before closing on a loan with a construction reserve, it is crucial for the Borrower to understand how the Lender processes construction draws. Every lender has a slightly different process.

The simplest process Lenders may use is photographic or video evidence that the work is completed. This is most common with small budget Fix and Flip projects, which usually have simple construction requirements. If the draw schedule required the cabinets to be installed, the Borrower may submit their draw request evidencing the work has been competed to receive their funds. This process can be as quick as 24 hours.

In more complex projects, the draw request may require the Borrower to submit a budget indicating the line item they will be drawing against, the invoices from the contractor or sub-contractors, and lien releases. The Lender may then schedule a site visit by a third party vendor known as fund control provider to verify the work has been completed and to calculate the % complete, particularly if multiple draws are being used for one phase of the project. Once the Lender reviews the request, they will determine the amount to release. This process may take a week or two so Borrowers need to factor it into their construction timeline.

In both scenarios, the construction reserve served its purpose. It ensured the work was completed and, ideally, that the funds remaining in the reserve account are sufficient to complete the project.

Most Common Issues with Loan Draw Requests

The two common types of construction draws is a Fix Draw Schedule or the Percentage Completion Schedule.

The Fixed Draw Schedule is often used with a Fix and Flip Loan or Rehab Loan. These types of loans are often used by real estate investors to purchase, renovate, and sell a property for profit (see our article on a What is a Hard Money Fix and Flip Loan). The loan is usually short-term and based on the expected value of the property after renovation.

In a Fix and Flip Loan, the Lender may disburse a pre-determined fixed amount of funds to the Borrower at different stages of the renovation process. The disbursement of funds may be based on the completion of specific milestones, such as the installation of cabinets in the kitchen, or it may be based on the progress of the project as documented by a building inspection card issued by the local building department.

The disbursement process based on specific milestones is the easiest to use as the Borrower knows exactly how much they will receive and when. For example, once the cabinets of a new kitchen are installed, the Lender may disburse a pre-determined $35,000. This makes it easier for the Borrower to manage their cashflow for the project. The Lender can also easily determine if the work has been completed to their satisfaction and disburse the funds accordingly.

In more complicated projects with larger budgets, such as value-add multifamily projects, the Lender may use Percentage Completion Schedule as their calculation. In this scenario, the Borrower may request multiple draws for certain portion of the project due to its size. For example, if the cost of completing an earthquake retrofitted foundation is $500,000, the Borrower and Lender may agree to break up the cost into more manageable draws. Each draw would be calculated by matching the percentage of work completed to the percentage of the line item budget allocated to the foundation. The downside of this option is that the Lender’s perception of percentage complete may differ from the Borrower’s, leaving the Borrower short of funds between draws.

Because renovation reserves have specified requirements for funds to be released, it is very important for the Borrower to create an accurate project budget and construction schedule. Problems will quickly occur when the Borrower creates a budget that isn’t sufficient to complete the project, or the scheduled release of funds aren’t drafted appropriately leaving the borrower short of funds between draw requests. (Check out our article on the Top 5 Mistakes Made on a Fix and Flip Loan)

How to Submit a Draw Request

Before closing on a loan with a construction reserve, it is crucial for the Borrower to understand how the Lender processes construction draws. Every lender has a slightly different process.

The simplest process Lenders may use is photographic or video evidence that the work is completed. This is most common with small budget Fix and Flip projects, which usually have simple construction requirements. If the draw schedule required the cabinets to be installed, the Borrower may submit their draw request evidencing the work has been competed to receive their funds. This process can be as quick as 24 hours.

In more complex projects, the draw request may require the Borrower to submit a budget indicating the line item they will be drawing against, the invoices from the contractor or sub-contractors, and lien releases. The Lender may then schedule a site visit by a third party vendor known as fund control provider to verify the work has been completed and to calculate the % complete, particularly if multiple draws are being used for one phase of the project. Once the Lender reviews the request, they will determine the amount to release. This process may take a week or two so Borrowers need to factor it into their construction timeline.

In both scenarios, the construction reserve served its purpose. It ensured the work was completed and, ideally, that the funds remaining in the reserve account are sufficient to complete the project.

Most Common Issues with Loan Draw Requests

The most obvious issue with the construction draw process is that the construction budget isn’t sufficient to complete the project. This usually occurs when the Borrower isn’t provided with a feasible budget from their contractor, there were issues over the course of the project that resulted in a higher budget, or the Borrower used proceeds from the project to fund another project.

Another common issue is that the Borrower submits incomplete draw requests, which is why it is critical that Borrowers understand a Lender’s draw process. Submitting incomplete draw requests will result in delays on the release of the funds and may cause friction between the two parties.

Cost overruns that require the Lender to either modify the draw schedule or the Borrower to bring in more cash equity is another common issue. Because the Lender wants to mitigate risk to their loan, they want to ensure that there are sufficient funds to complete the project. Therefore, any change to the budget will require Lender approval and may result in the loan being underwritten again. In this scenario, it is important that the Borrower notifies the Lender as soon as possible of any potential cost overruns and quickly agree on a solution.

Conclusion

A Construction Reserve is often used for construction loans or fix and flip loans to improve the chances the project is completed successfully. The construction reserve reduces the risk to the Lender that there aren’t sufficient funds to complete the project. To ensure the reserve is created correctly, Borrowers must provide Lenders with an accurate budget and scope of work. Borrowers should also have a clear understanding of the construction draw process. By creating a construction reserve with accurate figures and clear process of disbursing funds will help ensure a successful project.

About Author

Brock VandenBerg is the President of TaliMar Financial and the Fund Manager for TaliMar Income Fund I. Brock started his career in real estate finance in 2000 as a financial analyst with KeyBank Private Equity Group and the Federal Deposit Insurance Corporation (FDIC). Brock established TaliMar Financial in 2008 to provide a direct source of private capital for real estate investors and operators. In 2021, Brock launched its own mortgage fund, TaliMar Income Fund I, to offer Borrowers better access to capital and its investors a more consistent approach to investing in real estate debt. TaliMar Financial is proud to have funded over $350 million in loans and currently manages an active loan portfolio of over $50 million.

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